Market Wrap, Thursday, 10/16/2008

Predictable Wave of Human Emotions

by Keene H. Little

It was just another day for an 800-point swing for the DOW. Nothing exciting.
I was watching futures action before the market opened this morning and just
smiled at the thought of how we're getting used to (if that's possible) these
violent swings. Just before 9:00 AM to the low at 9:30 AM the DOW futures
dropped about 240 points, then rallied 140 points in the next 20 minutes and
then proceeded to shed more than 500 points in the next 90 minutes, gained back
those 500 points in the next
90 minutes and we hadn't even made it through lunch
yet. Then the DOW gave up 276 of those points into the early afternoon before
tacking on 580 points into the afternoon high.

And what's amazing is that the "little" pullback of 276 points in the middle of
the day looked like just a small correction. Do you remember when (just last
year?) a move of 100 DOW points was a big day? Trading 40 points on the DOW
futures was good for a $200/contract trade and you could make some good money.
Now you'll be lucky to survive with a 40-point stop. Welcome to the land of
volatility (which pulled back from another new high (81.17) this morning). This
kind of
volatility also plays hell with spread traders. One day you're panicking
about getting run over and the next day you've got a 100-point cushion on your
SPX spread. The next day you're panicking again. It could be like this for a
little longer before the market starts to quiet down again (but not like it was
in 2007).

As you know, I track the stock movements by counting to 5 and saying my ABCs as
part of EW (Elliott Wave) analysis. An impulsive move is a 5-wave move and a
correction is a 3-wave move (or some variation thereof). As I've been counting
the move down from last October, and then the May high and then the August high
and then the September high, I've been expecting a large drop (we got it) to be
followed by stair-stepping lower. This will be done in order to complete the
wave count and
several degrees of 4th and 5th waves to the downside have yet to
finish. In a nutshell what this means is that the market is about to become more
difficult to trade since this stair-stepping lower is going to be full of chop
and whipsaw price action. Throw in the high volatility and we're going to see
many more days like today. Get used to it, or at least understand that the risk
of getting whipsawed out of your trades is now going to increase.

One of the reasons I like EW analysis is because of the repetitive patterns, or
fractals, on different time frames. When reviewing stock market patterns it
becomes clear that many similar patterns repeat. You'll see repetitive patterns
in the same time frame and you'll see them in different time frames. They behave
the same and it's what gives us the ability to trade the charts technically
without a care about news, fundamentals, full moons, etc. Some common patterns
(fractals) that
we've heard about are head and shoulder patterns, bull and bear
flags, cup and handles and pennants and other triangle patterns. I use EW
analysis to identify the wave count that shows up as these patterns.

The point of this is that we human beings react very predictably to stimuli. For
us traders the stimulus shows up in the price action. The swings in our emotions
cause us to feel fearful or greedy. Depending on how we feel we are either
bullish or bearish and as a group we collectively show these swings of emotion
in the stock charts. As much as we might believe we're contrarians it's actually
very hard to accomplish. We instinctively react with crowds and herd behavior is
what's reflected
in the stock market movements. We're simply hard-wired to react
the way we do because our lives literally depended on it back in the days when
our very survival depended on reacting and moving in concert with our group. If
a saber-tooth tiger was about to attack the group it was not a good time to be a
contrarian and start thinking of ways to be different than your cohorts who were
running for their lives. The gene pool of those contrarian thinkers ended up in
the belly of the
tiger. In our evolution the stock market is very new for us and
our brains are not wired properly to discern what's going on and how to react to
it. Herd mentality may have given us the survival skills to get here but they
hurt us in the stock market. The common patterns we see on the charts reflect
the herd's emotional swings and provide us a way to do something different.

The stock market crash during the past month was really quite predictable if you
study past patterns leading up to where we were and what was likely to happen.
Parabolic rallies follow a predictable pattern and stock market crashes do as
well.

Take a look at the pattern of the 1929 crash:

DJIA, the stock market crash of 1929

Once the uptrend line was broken prices experienced a waterfall decline into the
end of October, had a strong 2-day rally and then 7 more days of hard selling.
After experiencing a waterfall decline into the low last Friday we had a strong
2-day rally into Tuesday's high. This morning marked the 2nd day of selling
following that 2-day rally. Does that mean we have 5 more days of selling ahead
of us that will take us to new lows? This chart should have you going hmm...

Not all patterns repeat of course. It's not a fool-proof way to trade. If it was
we'd be fabulously wealthy and not sitting in front of a computer screen all
day. Well, some might anyway. But since patterns often repeat, this chart should
have us paying attention to the possibility that we'll see some hard selling
continue into next Wednesday, October 22nd. I'll show that potential on
tonight's charts.

To those who say we've got much more interference from the government and that
this time it's different, I'd say you're right. But as Secretary Paulson said
today, we have several more difficult months ahead of us and that it is
difficult to force banks to lend. This is the first time I've heard a government
official recognize that turning a fire house onto the banks and refilling their
coffers with cash is not necessarily going to get them to lend it out. They
continue to be fearful
of not getting it back (thus the high interbank lending
rates) and they're hoarding the cash instead. It's a natural reaction and simply
part of the pendulum swinging back from excessive (irrational) exuberance. This
too shall pass but not without some time to heal. And unfortunately that means
some more pain ahead but we're certainly closer to a bottom than we were a month
ago (astute statement on my part you must admit).

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So even government interference, while causing short-term aberrations in the
charts, can't stop the herd's reaction to danger. Giving the banks hundreds of
billions of dollars in cash does not wipe away the fear that bankers have about
lending that money out or that borrowers have in borrowing it. The banks don't
want to lose those precious dollars just given to them and they'll hoard it.
Borrowers know they're too deep in debt and are starting to actually pay down
their credit cards
(finally!). The persistently high credit spreads, such as the
LIBOR (London Interbank Offered Rate) and TED spread (spread between the 3-month
Treasury and 3-month LIBOR) reflects this fear of lending among bankers. The
good news about the TED spread is that it has dropped back down some, closing at
4.07 today (after reaching a closing high of 4.64 last Friday). It's a small
sign that some fear is starting to dissipate. How long it will last is the $64K
question.

The fact that commercial paper continues to dry up says lending is certainly not
increasing. For the fifth straight week the commercial paper market has
declined, dropping by $40.3B (-2.6%) in the past week. The good news, for now,
is that the rate of decline has slowed. The bad news is that the interest rates
for these loans remain very high (unsecured, lower-rated 30-day paper costing
6.05%). Financial firms (the ones getting all the taxpayer money) issued $36.4B
less in the past
week which is a -5.6% decline. So between a high interbank rate
and shrinking commercial paper market, the credit market remains in dire
straits.

The governments around the world are doing whatever they can to get the lending
institutions some cash through investments and by buying their toxic assets such
as mortgage-backed securities. And what of these securities that the government
is getting in return for the handing out of so much money? Good cartoon says it
all:

Collateral offered for taxpayer dollars, courtesy slate.com

And with that let's move on to tonight's charts, starting with the weekly SPX:

S&P 500, SPX, Weekly chart

First thing I want to point out is a Fibonacci time window of 55 weeks from the
October 2007 high which falls on the last week of this month. There are some
other shorter-term Fibonacci time windows that call for a possible turn next
week. Therefore we should remain alert for a possible market turn next week or
the week after. Considering the market is declining into this window we should
assume it will be a bottom (for how long can't be known).

SPX has been bouncing around the broken uptrend line from 1990 and the price
level near the 2001 low and 2002 highs (about 950) but hasn't quite made it down
to the 2002 low near 768. If the market consolidates for a week or so I strongly
suspect we'll hit the October 2002 low before the end of this month. That would
be quite the anniversary of that low. But then, as depicted, we would not be
finished with the decline from October. After another bounce/consolidation we
should get another
low that breaks the 2002 low and eventually see SPX work its
way down to the 1996 low near 606.

S&P 500, SPX, Daily chart

I'm showing one idea for a consolidation pattern that runs into next week--a
large sideways triangle (shown in dark red and labeled wave (iv) at the end of
it). This is a very common pattern for 4th wave corrections which is where we
are in the EW pattern (one of a few 4th waves of larger degrees that need to
play out). The other possibility is for a sharper a-b-c rally, shown in pink,
which calls for a stronger rally into next week before tipping back over again.
When asked what could
spark such a big rally (SPX 1070-1080 potential) my only
though is another Fed rate cut.

Not shown on the daily chart but is shown on the 60-min chart below is another
possibility for an immediate decline following today's rally.

Instead of a larger bounce up from Friday's low, as part of either the large
sideways triangle or sharper rally shown on the daily chart, we might have
completed only the 1st wave down in what will be a 5-wave move lower from
Tuesday's high. Today's rally is only a 3-wave bounce and therefore a good setup
for the short side for a continuation lower on Friday (shown in dark red). This
scenario would look best with an immediate decline on Friday. It could tolerate
a little higher but
anything back above 1000 would be a strong indication that
we'll see a move up to the 1070 area.

Dow Industrials, INDU, Weekly chart

The DOW has made an attempt to get back above its broken uptrend lines from 1982
and 1990 but so far no luck sticking above them (about 9150 and 9475). The
pattern to the downside looks incomplete at this point and I expect to see it
head lower to potential support surrounding its October 2002 and March 2003 lows
(7197 and 7416, resp.). I show a stronger bounce up into the end of year and
early 2009 after the new low but I could be a bit early in making that kind of
projection. The
daily chart shows those support levels will probably break
before get a bigger rally.

Dow Industrials, INDU, Daily chart

The wave count is the same as SPX in calling for at least one more down-up-down
sequence before we see a longer-lasting bottom in November. Some folks whose
analysis I trust, Jeff Cooper being one, are using Gann tools to call a bottom
around mid November and the pattern depiction on the DOW agrees with that.

NDX made its high in October 2007 a few weeks after the DOW and SPX. It was part
of the bearish divergence that set up at the time and gave us a heads up that
something was wrong with the rally. Measuring a Fibonacci 55 weeks from its top
gives us a potential turn window in mid November, which agrees with the Gann
folks calling for a turn around the same time.

The EW count I've got on this chart does not call for a significant turning
point in mid November but only a bounce before it continues lower into the new
year. Assuming the market will stair-step lower into November I will be
attempting to "square up" the different indices to see which one is giving me
the better picture. For now it's immaterial since they all are calling for lower
lows into either the end of this month or into November at a minimum.

Nasdaq-100, NDX, Daily chart

Sticking with a relatively wide down-channel for NDX shows it needs to rally
quite a bit just to break out of its down-channel. I try to identify potentially
important lows long before that happens so as to capture as much of the move as
possible. I see a strong possibility for the decline to simply continue from
here (dark red) and see NDX approach its 1998 and March 2003 lows (about 940)
before the end of the month. It could find support higher--watch the trend line
along the lows
from July and last week.

I've kept the trend lines from August 19th (along the August and September lows)
and September 19th because, along with the broken downtrend line from October
1st, to show how price action is reacting around them. Today's close stopped at
the August 19th trend line and counts complete as a 3-wave bounce off this
morning's low. It doesn't mean it will reverse here and head for new lows (dark
red) but it's a setup for it. Therefore any turn back down on Friday morning is
a sell signal.
A rally above today's close would set it up for a rally at least
up to the 1400 area.

Russell-2000, RUT, Daily chart

The RUT was in a world of its own back in August and September, holding up
better than the others. I therefore have a different wave count on it but it's
essentially the same picture--it either found a tradable bottom last Friday
(pink) or else it's got some more downside work to do (dark red). The key levels
are 100 points apart so not exactly helpful here. In between those levels we
could see lots of chop if price is going to consolidate sideways before heading
lower again.

BIX bounced back up to the top of its primary down-channel from October 2007 (it
has stayed inside this down-channel except for its brief excursion into the
unknown in September before returning to the safety of its channel). If it
manages to push a little higher it's got its 50-dma near 182 to deal with. Its
pattern is not yet complete to the downside.

U.S. Home Construction Index, DJUSHB, Weekly chart

I'm showing a longer-term scrunched weekly chart of the home builders to keep in
perspective where it was and where it is. It's got two parallel down-channels
I'm watching, the shorter-term one for this year's price action and of course
the one from the 2005 high. As I've been stating for a while now, I believe the
home builders index is close to a bottom. It might have another up-down sequence
to go and I foresee a slightly break below its 2001 low at this time but it's
not an index
(or stock) I'd be interested in playing--it's dead money for a
while.

Transportation Index, TRAN, Weekly chart

The Transports were also doing their own thing this year and even made a new
high out of their efforts. I remember wondering at the time what these traders
were smoking. Whatever it was it apparently made them sick since they quickly
disgorged themselves (trying to be nice here) of the transportation stocks they
were so in love with only a month ago. As depicted, the wave pattern needs a bit
of consolidation in a 4th wave correction and then a 5th wave low before its
decline should
be complete. A Fib projection down to 3243 means a slight break
of the 2005 lows near 3380.

And talk about disgorging, one look at the monthly chart of commodity stocks
says it all:

Commodity Related index, CRX, Monthly chart

Anyone who has studied parabolic rallies and their eventual demise is not
surprised by this chart. Next potential support is the 78.6% retracement near
379. A break of that level would mean a likely retracement of the entire
2002-2008 rally. I keep expecting a big corrective rally before heading lower
again but so far no signs of it.

Gold Fund, GLD, Weekly chart

Gold's rally from 2005 is being threatened again. After bouncing off its uptrend
line in September, and looking quite bullish there for a while, the drop back
down towards the trend line does not look bullish. A break of the trend line
would likely mean GLD is headed for the 60 area ($600 gold) but there's still
hope for gold bulls as long as the September low of 72.51 holds.

Oil Fund, USO, Daily chart

USO dropped back down into its down-channel from July and made it to the bottom
of the channel where it could find support. Whether that support leads to a
rally up and out of the channel or just a bounce before continuing lower is the
big question here. Based on the wave count I don't think we've come close to
finding a low for oil. Good news for cash-strapped consumers and the consumer
price index but it's bad news for showing signs of economic malaise leading to
lowered demand for
oil. I believe it's another sign that we'll soon be hearing
more about deflation than inflation (and another reason why I think gold will
also break down).

Economic reports, summary and Key Trading Levels

The housing numbers tomorrow should not be market moving. Even if it does move
the market in the morning it should only cause a 200-point ripple in the DOW
(wink). This market is worried about a lot bigger things than economic reports
right now. Even earnings announcements cause some ripples but those are quickly
pushed aside as the bulls and bears duke it out at these lows.

I'm still in the bear camp as I believe the market has some more bad news to
deal with. I don't think it's fully priced in the severity of the recession
we're facing, nor the problem with deflation that I believe is coming. But I
prefer to stick with the charts and right now the wave pattern is very clear in
its need for more work to the downside. We have entered the period where we'll
see bounces/consolidations get bigger and take longer. It will be accompanied by
multiple bottom
calls (like last Friday's, and the bottom before it and the
before it and...).

When calls for the bottom stop, along with confidence about where we are in the
wave pattern I hope to be one of the first to start recommending longer term
long plays. I'm tired of being called a permabear (although sticks and stone can
break my bones...) and I look forward to joining the bull camp where I suspect
I'll feel lonely again. Frankly it's starting to get a little crowded in this
bear camp.

But I think we're still perhaps a month away before I'll even consider a
multi-week long play (other than speculative plays that I'll call out on the
live Market Monitor where I know people are watching the market during the day).
Surprises will still be to the downside so stay very cautious if you're
attempting to time the bottom. I've reduced my exposure to the short side of
this market but it's too early to start thinking long. I'd rather be out early
from my short position and
sitting on the sidelines than be in early on the long
side.

Summarizing what I see in tonight's charts, first thing is a setup for the short
side heading into Friday. But this setup requires, preferably, an immediate
start back down in the morning. Today's rally off the low achieved two equal
legs up at the close so that's why it should start right back down if today's
rally was simply a correction of the decline from Tuesday.

If the rally continues then I see the possibility for a push back up near
Tuesday's highs before turning back down within a large sideways triangle
pattern. We might get a pullback first thing tomorrow and then a continuation of
the rally so any pullback followed by a break of today's highs would be at least
short term bullish.

The other bullish possibility is for a stronger rally leg above Tuesday's high.
Look for SPX 1070-1080 and DOW 10K in that case. DOW 10K is only a 1000-point
run and I think this market can handle that now.

Downside potential if we start selling off again is for a quick break of last
Friday's lows, small bounce and then continuation lower into early next week.

Good luck and stay careful in this wild market. I'll be back with you next
Thursday.